Spousal lifetime access trusts can help ultrawealthy couples reduce estate taxes, but advisors must be careful when both spouses establish them. If the two trusts are too similar, the IRS could challenge the arrangement.
A type of irrevocable trust, a SLAT allows one spouse to transfer assets out of his or her taxable estate while naming the other spouse as a beneficiary. The transfer uses part of the donor spouse's lifetime gift and estate tax exemption, and the beneficiary spouse can receive distributions according to the trust's terms.
The planning process becomes more complicated when both spouses set up SLATs for each other.
The key is to make sure the two SLATs are economically different, said Martin Shenkman, partner at the estate planning boutique law firm Shenkman Tietz. For example, one trust could be invested in stocks and the other in bonds, or one could have a life insurance policy. Although clients will need to consult a lawyer to establish a trust, advisors can take actions such as these to help differentiate trusts.
"If they're identical, you're vulnerable to the IRS applying what's known as the reciprocal trust doctrine," Kevin Matz, New York-based partner and co-leader of the family office industry group at law firm ArentFox Schiff, said in an interview. "Effectively, you're trying to be too cute."
In other words, the IRS might decide the assets one spouse is transferring are really for that spouse's own benefit, he said. Violating this "reciprocal trust doctrine" can mean losing the tax benefits.
"Lots of people write articles and talk as if they know what you need to make the trust different. The law is not clear," Shenkman said. "There's no bright-line test that if you do A, B and C that the trusts definitely are different enough."
Though they can be useful, SLATs remain a relatively niche strategy, generally suited to wealthier households and not appropriate for all clients.
"In my practice, I probably did it less than 10 times with clients, and these were mostly clients who were business owners," said Erin Botsford, a former advisor who now trains others as founder and CEO of The Advisor Authority. Setting up a SLAT requires an attorney, she said.
Why clients might use SLATs
When structured properly, SLATs can offer clients some estate planning advantages. SLATs should be designated as grantor trusts, so donors are responsible for taxes on the assets, said Joe Sicchitano, head of workplace personal investing and individual solutions at investment management and insurance firm Principal Financial Group.
"Assets that are inherited at death typically get a step-up in basis," Sicchitano. "That's true with portability. It's not true with assets that are inherited through a SLAT. So you do have to worry about what type of assets are put into a SLAT if that step up in basis matters."
Estate tax savings are not the only benefit from SLATs. Another potential advantage relates to generation-skipping taxes.
"If you properly set up a SLAT, you can also take advantage of generation-skipping tax exemptions," Sicchitano said. "So if your ultimate target for the beneficiary is actually the generation that follows your spouse, SLATs are usually a good idea because you can preserve that generation-skipping tax exemption at the time that you're building up those SLATs."
Common planning pitfalls and risks
Setting up a SLAT for a client can present some challenges and potential issues that advisors should be aware of, experts say.
Be careful in case of divorce, if there was no prenuptial agreement, Matz said. The ex-spouse might end up claiming "a very substantial portion of it."
Meanwhile, when passing down wealth to the next generation, using a trust can be similar to having the children and their spouses sign prenuptial agreements.
"What you're doing with a trust is you're creating, in effect, a prenuptial agreement for your children, for the descendants, without actually requiring to have a prenup, at least with respect to inherited wealth, because you're going to keep the wealth in your bloodline for generations to follow — have the ability for assets, including potentially homes, to be owned," Matz said.
A general concern about not only SLATs but also other types of trusts is that advisors should make sure clients remember to fund them.
"One of the pitfalls of good estate planning is if people don't actually fund the trust," Sicchitano said. "They have this beautiful document that outlines a trust, but they never put any assets in it."
Some people incorrectly believe they don't have to fund their SLATs because of portability, he added.
Adding in-laws to a SLAT?
Beyond basic estate planning benefits of SLATs, they may also be used in tax basis planning.
One such strategy involves giving an in-law general power of appointment — allowing the person to appoint the assets to oneself, one's estate or one's creditors — so there can be a step up in basis after the in-law's death, Shenkman suggested. This approach could help a client who, for example, has $2 million of highly appreciated stock.
"Think of how much of a happy dance they're going to do for their financial advisor if he made all their capital gains go away," Shenkman said. "That's what this does. This should be on everybody's radar."
Matz agreed it is possible to give an in-law general power of appointment. Potential downsides, however, include that the in-law could give funds to some other person and that the in-law's creditors could try to access the funds after death, he said.
"It can be an appropriate tool if limited carefully, but you always have to say: What were the consequences here if it were, in fact, to be exercised, or if predators were to try to get at it?" Matz asked.
The client's relationships with family members are also important to consider before giving, for example, a mother-in-law general power of appointment.
"I think I'd have to make sure that I had a really good relationship with my mother-in-law," Sicchitano said.
